Prospects Weekly: European banking under some pressure

Submitted by Global Macroeconomics Team
On Tue, 07/06/2010

Last weekend the G-20 convened in Canada, and while recognizing that countries need to adjust fiscal accounts at different speeds, the high-income economies agreed to halve their fiscal deficits by 2013 and stabilize debt-to-GDP ratios by 2016. Planned budget cuts across the OECD through 2011 could amount to $560bn, or 1.4% of GDP. Monetary authorities in high-income countries are expected to hold-off on policy interest-rate hikes, given fiscal-consolidation efforts. But, developing-country rates are expected to continue to rise as recovery takes hold. As a consequence, rising interest rate differentials are likely to prompt a rise in carry trade activity and associated capital flows. An upswing in Euribor rates since May reflects heightened risk-aversion, concerns about European bank-exposures to bad debt, and an increase in funding demand as €442bn in ECB emergency-loans came due today. These concerns—combined with mounting evidence of a coming slowdown in global growth in 2H-2010—contributed to a sell-off in global equity markets, with the World MSCI down 4.3% in the last week (as of July 1).

The G-20 appears to have reached consensus on a “growth friendly” approach to budget cuts. IMF suggestions that “one shoe does not fit all” and the U.S. Administration’s view that recovery is too fragile for “traditional” budget cuts, received some support from the Europeans. Greece, Ireland, Portugal and Spain have announced measures to reduce budget shortfalls by some $82bn, or 4.5% of their GDP through 2011. Larger countries of Europe are also moving toward deficit reduction, with cuts amounting to $75bn. These range from 1.8% of GDP for Italy, 1.6% for the U.K. and 1% for France through 2011. The measures are targeted to achieve sustainable public sector debt-levels, and in turn hoped to stave off worse consequences from ongoing fiscal problems.

Large interest-rate differentials between developing- and high-income countries are likely to remain or widen, increasing carry-trade opportunities. While central banks in a handful of high-income countries (including Australia, Canada, and Norway) have recently raised short-term policy rates—many high-income countries are expected to refrain from raising rates until private sector activity has gained firmer footing, especially with plans to tighten fiscal policy. As monetary policy continues to tighten in developing countries, incentives to undertake carry-trades may intensify with investors borrowing short-term at lower interest rates in high-income countries to invest in higher-returning instruments in emerging markets—potentially generating unwanted and disruptive capital flows.

Euro interbank offer rates (Euribor) have risen since May and continued to increase today, as €442bn in ECB emergency loans came due. Funding pressures associated with the repayment (€199bn has been paid off) may have contributed to the recent climb in Euribor. However, a generalized increase in risk aversion, and specific fears about the solvency of some European banks may also have been at play. Of the €243bn of ECB debt that was rolled over, €111bn was put into six-day loans—suggesting that debtor banks still hope to repay this debt in the days to come using private-sector funding. How successful they are in doing so will be a key indicator of banking-sector health. As repayment-related demand eases, Euribor rates should begin to decline.